Chapter 1

Fundamentals of Engineering Economics

1.1 Water Resources Economy

When a water resources project is operated, it produces a time-pattern of
economic consequences. Since large sums of money and other resources are
involved, it is necessary that the consequences be carefully predicted and
compared before the project is taken up for execution. For example, consider
that a dam is to be constructed in a basin to provide water for irrigation,
municipal and industrial use, generate hydropower, and control flood. The
reservoir may also submerge villages, and agricultural and forest areas, and
people may have to be rehabilitated and resettled. Different locations and
different heights of the dam will produce different patterns of desirable and
undesirable effects. All the benefits and costs must be suitably considered to
determine the best project configuration.
Water resources economics focuses on applying economic criteria to identify
efficient choices, given the demands, supplies, and a number of alternatives.

1.2 Principles of Engineering Economics

The basic principles of engineering economics guide the structuring of
alternatives so they may be compared to determine which should be selected.

1. Equivalence of Kind: In order to make realistic investment decisions, all

alternatives must have a common value unit. For example, consider two
alternative irrigation projects, one provides water for grapes and the second
for cotton. Construction of the first project will produce x tons of grapes.
Construction of the second project will produce y bales of cotton. The projects
cannot be compared using these different units. The proper approach is to
convert both tons and bales into a currency unit.

2. Equivalence of Time: Monetary amounts at different times should not be

directly compared or combined.
Future amount, F, may be made equivalent to present amount, P, by
multiplying by a discounting factor 1/(1 + i)N where i is discount rate or
return rate or interest rate, N is the number of unit time.
Chapter 4: Project Scheduling and Resources Allocation

F=P+ P N i … ( 1 )

N
F=P ( 1+i ) … ( 2 ) compounding factor

F
P= … ( 3 ) discounting factor
( 1+i )N

An investment of a dollar at an annual rate of return of 5% would yield $1.05

a year later. Similarly, $1.05 a year from now is equivalent to $1.00 now
when discounted at 5%.

3. Intangible Values: Items that cannot be expressed in monetary units such as:
• Market pressures, such as need for an increased international presence.
• Availability of certain resources, e.g., skilled labour force, water, power.
• Government laws that dictate safety, environmental, legal, social aspects.
• Corporate management’s or director’s interest in a particular alternative.
• Goodwill offered by an alternative toward a group: employees, county, etc.

4. Whose Viewpoint? Monetary value depends on the viewpoint taken in the

evaluation. In an engineering economy study, three viewpoints are possible:
• Considering only consequences affecting the group sponsoring or financing
the project.
• Considering only consequences affecting the people living in a specific
area such as a city, country or region.
• Considering all consequences to whomever they may accrue.

5. Sunk Cost: Past expenditure or sunk costs are past events that should have no
influence on deciding among alternatives except as they affect future cash
flow. Suppose $5 million have been spent on a hydropower installation
ultimately costing $10 million. A steam plant costing an estimated $3 million
is subsequently found to be capable of supplying the same energy. Which
facility should be selected, assuming all other future costs to be the same?
The $5 million already spent on the hydropower facility is a sunk cost, and
the remaining cost is less than the cost of the steam plant. Therefore, the
steam plant should be selected.
Chapter 4: Project Scheduling and Resources Allocation

6. Incremental Cost: According to this principle, the decision to enlarge a

project should be justified by the increasing benefits more than costs.
Consider a 10,000 acre-ft reservoir which a city determined to build for $1
million. Before construction begins, increasing the storage to 20,000 acre-ft
and the cost to $1.5million is found to achieve $600,000 in flood control
benefits. The correct incremental-cost approach would include flood control
since the additional $500,000 expenditure is exceeded by $600,000 benefits.

7. Predictive Uncertainty: Economic analysis usually compares future

consequences of engineering alternatives. The reliability of decisions depends
on the ability to predict future events. A project may only appear to be
economically feasible because of incorrect predictions. No matter how much
data or experience one has, predicting the future is uncertain.

8. Planning Horizons: The planning horizon is the most distant future time
considered in an engineering economy study. Actually, four different periods
of time must be considered in any economic analysis:
 Economic Life: ends when the incremental benefits from continued use no
longer exceed the incremental costs of continued operation.
 Physical life: ends when a facility can no longer physically perform its
intended function.
 Period of Analysis: is the time period over which the project consequences
are included in a particular study. The period of analysis for comparing
alternatives has the project economic life as its upper limit but may be
shortened to exclude the highly uncertain events of the very distant future.
 Construction Horizon: is reached when the constructed facilities are no
longer expected to satisfy the future demands. For example, the water
supply alternatives for a community may be studied for a period of analysis
of 40 years even though the original facilities may be planned to supply
water for only 20 years. The longer period of analysis helps integrate
present action into the long-run solution. The shorter construction horizon
adds flexibility to deal with unforeseen changes.
Regular maintenance and periodic replacement of worn parts may extend the
life of a water resources project, but a period of analysis of 50 or 100 years is
generally used. The optimum construction horizon for individual project
components is often shorter. For example, channels may be economically
enlarged in 10- or 20-year stages, whereas tunnels may be economically build
to maximum capacity because of the high cost of subsequent enlargement.
Chapter 4: Project Scheduling and Resources Allocation

9. Structuring Alternatives: The analyst should clearly define all alternatives

that are capable of achieving the design objective. Benefits and costs, the
physical consequences, and intangible values of each alternative must be
identified. One alternative is to “do nothing” if none of the other proposals is
economically feasible. Economic alternatives are categorized as follows:
• Mutually exclusive: Only one of the viable projects can be selected by the
economic analysis. Each viable project is an alternative.
• Independent. More than one viable project may be selected by the
economic analysis. (There may be dependent projects requiring a particular
project to be selected before another, and contingent projects where one
project may be substituted for another.)

1.3 Uniform Annual Series

It is the series of annual cash flow of equal amounts, A, at the end of each year
of the N years. A may be made equivalent to P and vice versa:

( 1+i )N −1
P= A
[ ]
i ( 1+i )N
… ( 4 ) series present −worth factor

i ( 1+i )N
A=P
[ ( 1+i )N −1] … (5 ) capital recovery factor

Furthermore, uniform series of annual cash flow, A, may be made equivalent to

F and vice versa:

( 1+ i ) N −1
F= A [ i ] … ( 6 ) series compounding factor

i
A=F
[ ]
( 1+ i ) N −1
… ( 7 ) sinking−fund factor
Chapter 4: Project Scheduling and Resources Allocation

1.4 Uniform Gradient Series

It is the annual cash flow that increases or decreases by some constant amount,
G, between years.

G1
G = G2 –G1
GN
Increasing Gradient

G may be made equivalent to P as:

N
G ( 1+i ) −1
P=
[
i i ( 1+i ) N
−
N
(1+i ) N ]
…( 8)

Uniform gradient series may be converted to uniform annual series, A, by:

1 N
A=G 1+G
[ −
i (1+i ) N −1 ]
… ( 9 ) Increasing gradient

1 N
A=G1−G
[ −
i ( 1+i )N −1 ]
… ( 10 ) Decreasing gradient

GN

G1 Decreasing Gradient
G = G1 –G2

1.5 Cash Flow Diagram

It is the graphic presentation of the monetary values plotted by time. Benefits are
represented by arrows pointing upward, while costs by arrows pointing
downward. The length of the arrow is made proportional to the cost or benefit.
The assignment of a monetary value to physical consequences is a very
complicated process. Cash flow patterns for economy studies are based on future
events and cannot be known with real certainty. Sometimes it may be better to
approximate a future cash flow pattern by using gradients over different periods.
Chapter 4: Project Scheduling and Resources Allocation

1.6 Nominal and Effective Interest Rates

In all engineering economy relations developed so far, the interest rate has been
a constant annual value. For many projects evaluated by professional engineers
in practice, the interest rate is compounded more than once a year; such as
semiannually, quarterly, and monthly. This requires the introduction of two new
terms—nominal and effective interest rates.

Nominal interest rate is also defined as a stated interest rate. This interest
works according to the simple interest and does not take into account the
compounding periods.

Effective interest rate is the one which caters the compounding periods during
a payment plan. It is used to compare the annual interest between loans with
different compounding periods like week, month, year etc.

In general stated or nominal interest rate is less than the effective one. And the
later depicts the true picture of financial payments. The nominal interest rate is
the periodic interest rate times the number of periods per year. For example, a
nominal annual interest rate of 12% based on monthly compounding means a
1% interest rate per month (compounded).

i n
( )
i eff = 1+
n
−1… ( 11 )

where: n is the number of divisions per year.

i eff is the effective interest rate.

For example, if a bond pays 6% annually and compounds semiannually, an

investor who places $1,000 in this bond will receive $30 of interest payments
after the first 6 months ($1,000 x 0.03), and $30.90 of interest after the next
six months ($1,030 x 0.03). In total, this investor receives $60.90 for the year. In
this scenario, while the nominal rate is 6%, the effective rate is 6.09%.
Chapter 4: Project Scheduling and Resources Allocation

1.7 Payback Period NP

This method estimates the number of years required for positive cash flows to
equal the initial investment. There are two types of payback analysis:

1- Simple payback (No return; i= 0%): this is the recovery of only the initial
investment.
t =N P

∑ NCF t −P=0 … (12 ) NCF t varies annually

t=1

P
N P= … ( 13 ) uniform annual NCF
NCF
where NCF is the annual net cash flow = cash inflows − cash outflows.

2- Discounted payback (i>0%): it considers the time value of money in

addition to recovering the initial investment.
t =N P

∑ NCF t ( P/ F , i ,t )−P=0 … ( 14 ) NCF t varies annually

t=1

P
N P= … (15 ) uniform annual NCF
NCF ( P /F ,i , N P )

Payback analysis neglects all cash flows after the payback period of NP years.
Consequently, it is preferable to use payback as a supplemental risk assessment
method rather than as the primary means to select an alternative.
The information obtained from discounted payback analysis performed at an
appropriate i>0% can be very useful in that a sense of the risk involved in
undertaking an alternative is provided. For example, if a company plans to
utilize a machine for only 3 years and payback is 6 years, indication is that the
equipment should not be obtained. Even here, the 6-year payback is considered
supplemental information and does not replace a complete economic analysis.

Homework (Ch.1:Fundamentals of Engineering Economics)

Chapter 4: Project Scheduling and Resources Allocation

1) A design-build engineering firm completed a pipeline project wherein the

company realized a profit of $2.3 million in 1 year. If the amount of money
the company had invested was $6 million, what was the rate of return on the
investment? (Ans. 38.33)
2) An irrigation system has been constructed by Ministry of Water
Resources. The system is to be replaced after 15 years with an agreement
that the farmers have to pay the replacement cost which is $437,500 with a
discount rate of 11%. How much is the annual amount that the farmers pay?
(Ans. $12,716)
3) Income from recycling water has averaged $3000 per month for 2½ years.
What is the future worth of the income (after the 2½ years) at an interest rate
of 6% per year, compounded quarterly? (Ans.$96,324)
4) An investment of $10,000 can be made in a period that will produce
annual revenue of $5,310 for 5 years. The annual costs will be $3,000
yearly. Estimate the simple payback period for this project. (Ans. 4.33 years)